Fixed Costs Vs. Variable Costs
My name is Chris Devlin. I’m a portfolio manager at Wealth Management. We specialize in analyzing publicly traded companies, going through financial statements and looking at profitability. We’ve been doing it for several years now, and we were asked to go over fixed versus variable costs. I think this will be a really beneficial lesson for local business owners, especially to learn about how these different types of costs can impact your profitability in the business that you’re operating.
These two different types of costs can be categorized. One as fixed costs, which are any expenses you incur that are not dependent on business activity, or to put that in plain English – there bills that you have to pay no matter how much business that you do. Some examples of would include rent, so let’s so you’re operating a cupcake shop here in town, your rental expense you have to pay no matter what. It doesn’t matter how many customers are coming in and out of your business – you’re going to incur those expenses. Other examples would include a mortgage if you owned your building, insurance you have to pay in order to operate your business, and also equipment expenses for a lot of different types of businesses. These are examples of fixed expenses – things you’ll incur no matter how many customers that you serve.
The second category that we’re going to cover today are variable costs. Variable costs are expenses that are dependent on business activity. To put this another way, imagine that you sell sandwiches. This would be the cost of each sandwich – your bread, ham, lettuce, tomato… Every time you sell an additional sandwich, it’s going to increase your cost as a business owner. Some other examples of this include hourly wages, commissions, and materials used in production. That’s probably the most common form of variable costs for business owners. Materials can include anything from burritos at Chipotle, coffee at Starbucks, or even jet fuel for American Airlines. These are all different types of variable expenses, and they all go up or down based on how many customers they serve.
Then there are some expenses that fall somewhere in between. For example, salary wages would be harder to classify, or utilities. If you’re running a restaurant, you may need your utilities just to keep the lights on, and the number of customers doesn’t really impact what your bill is. But if you’re running a factory, electricity can be a huge input into your production costs. For every type of expense that you incur, you just need to think about does this go up or down with the level of business activity as you’re producing goods for your customers.
Why do fixed costs and variable costs matter? Fixed costs are the ones I think are most intimidating for business owners. If you don’t cover your fixed costs, you’re going to go out of business. If you can’t make your rent payments, you’re going to have to close up shop. Variable costs are a little less intimidating. Variable costs only grow as your business activity grows, so the more customers that you serve, the more expenses you’re going to incur. But it can be a really good problem to have, because it can mean that business is booming.
So to illustrate these two types of expenses, I think it’d be best to use a real-life example. Most of us are local here, so we’ll talk about the Chipotle down on Wards Road. Now we don’t know that exact rental expense at Chipotle, but I’ll estimate at around $4,000 per month. That would be a fixed expense for Chipotle – they have to pay that every month no matter how many customers come in and out of their doors. In order to do that, they need to sell burritos. So a chicken burrito at Chipotle costs $7.60 – that’d be the sales price. They also have a variable cost associated with that, which is how much it costs to make each burrito – that’s for the rice, beans, and the wrap. The variable cost for a burrito is roughly $1.76. If you take the sales price minus the variable cost, you arrive at the gross profit per burrito, which is roughly $5.83. So a very important question for business owners is how many burritos would I have to sell in order to cover my fixed expenses? No matter what type of business you’re running, this is something you’re going to have to look at. How many goods or units am I going to have to sell in order to break even on my expenses? In the case of Chipotle, we can just take the $4,000 in rent and divide it into gross profit per burrito, so $4,000 divided by $5.83 would be roughly 685 burritos. The Chipotle down on Wards Road sells that many in roughly two days. So 685 units is required in order to cover your fixed expenses, and covering your fixed expenses is very important because everything you sell beyond that becomes profit for you.
So a really important question for business owners then when they’re looking at fixed versus variable costs is how do you maximize your profit? It’s a very important question and there are basically two key things you need to accomplish in order to maximize profitability. The first is to minimize your fixed costs without subtracting from your customer experience. If you can keep your rental expenses low, your insurance payments low, and all of your fixed costs low, your break even point will be lower, so you can do less business while still being profitable. The second most important thing to maximizing profit is to actually maximize your gross profit. Don’t worry about your variable costs. And I’ll kind of explain this a little bit.
So lowering prices can lead to lower profits per customer, but many more customers. So we’ll take two examples. Imagine you were selling $1,000 burritos at a $5.83 profit. That is much more profitable than selling 600 burritos at $8.00 profit. The first scenario would generate around $4,800 in gross profits, while the second scenario is $1,830. And considering the fixed costs, these numbers become even more significant. In the first scenario, when you’re paying $4,000 in rent with $4,800 in gross profit, your net income is only $800. Whereas in the second scenario, income increases to $1, 830. That’s a 128% increase in income just by lowering prices and selling more.
So here are the key takeaways of fixed costs versus variable costs. Fixed costs don’t change based on business activity, whereas variable costs increase as you do more business. And again, the goal is to minimize fixed costs while aiming to maximize gross profits. Don’t worry about increasing variable costs as you do more business. As long as your gross profits are maximized, it’ll maximize profits for you as a business owner. And again, don’t be afraid to lower prices if it generates more business. I think this is an error businesses make when they’re first starting out, but as long as you’re maximizing your gross profits, it’ll lead to success.
About Christopher Devlin
Chris Devlin is the founder and Chief Investment Officer at Selective Wealth Management, an asset management firm located in Lynchburg, Virginia. Chris graduated from Pennsylvania State University in 2007 with a degree in Nuclear Engineering.
After graduation Chris worked as an engineer at Areva and was responsible for criticality analysis during reactor startups. During this time he received his real estate brokerage license, real estate appraisal license, and founded an investment partnership, Charis Equity LLC. He received a Masters in Theology and Apologetics from Liberty University in 2012. In 2013 Chris founded Selective Wealth Management and has been the Chief Investment Officer from inception posting returns in excess of the S&P 500 in 4 out of the first 5 years.
Selective Wealth Management increases the wealth of clients by purchasing dominant and debt free companies with outstanding growth potential at brilliant prices. They're financial performance ranks above the 97th percentile amongst active wealth management advisors. Since inception, they're proprietary selective process has beaten the market.
Chris has held seats as a member of the board for the Farrr Foundation, Gospel Community Church, the Rose Initiative, and received recognition for his business leadership and community involved by winning Lynchburg’s “Top 20 under 40 Award” in 2015.
|Date Added||July 5, 2016|
- What is fixed cost?
- What is variable cost?
- Why do they matter?
- How do I meet my fixed expenses?
- How do I maximize my profits?